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Saturday, May 8, 2010

Investing--The New Rules: Beat the Odds

If you follow a Buy-and-Hold strategy, you are the gambler. Do gamblers sometimes win? They do indeed. And Buy-and-Hold generated great returns in the late 1990s.

But you don’t want to be the gambler, you want to be the house. Is there a way for the stock investor to get the odds on his side? Is there a way to be sure that you won’t occasionally win some but then give most of the winnings back later on, to insure that over the long run you will almost certainly end up a winner?

He doesn’t win every bet any more than the house in a casino wins every bet. But he never sweats it. Like the house, Buffett knows in advance that the odds are on his side. His long-term edge gives him the feeling of confidence that makes investing fun.

There’s only one problem with the Buffett approach. It’s hard. It takes a lot of work. Most of us don’t have the time or skill or energy to pull it off. We are better off not trying.

Fortunately for us lazybones types, there is a second way that works almost as well. The reason why the Buffett approach is so much work is that there are a hundred factors that can determine whether a company is successful for not. If you miss one factor and it turns out to be important, there goes your hope of being the house and not the gambler. We lazybones types need an approach to getting the odds on our side that only requires us to check out a single factor and then permits us to roll over and go back to sleep.

We’ve got it!

It’s called indexing. When you buy an index fund, you are buying a share of the productivity of the entire U.S. economy. You don’t need to bother figuring out whether a company has good management or a competitive edge or is sufficiently capitalized or any of that other boring junk. It’s always going to be the case that some of the companies in the U.S. economy are going to have good management and that some are not, that some are going to have a competitive edge and that some are not, that some are going to be well capitalized and that some are not. Buy indexes and you get a mix of all of them. You won’t do as well as if you put in the effort to separate the sheep from the goats. But you’ll do pretty darn well all the same.

How well? The U.S. economy has been sufficiently productive to generate an average long-term return for stock investors of 6.5 percent real for 140 years now. That’s what you can expect if you become a follower of the lazy Buffett approach to investing.

Now -- I need to make a very, very, very important point. Indexing is the answer for the typical middle-class investor. But John Bogle and the other Buy-and-Holders have given indexing a bad name with the tireless promotion of their misleading marketing slogans.

I advocate a reformed Bogle approach called “Valuation-Informed Indexing.” This approach incorporates the critically important lessons we have learned from the academic research of the past 30 years. It is not an indexing approach that will eventually leave you busted, as Bogle’s will. It is an indexing approach that works in the real world.

To understand why valuations are so important, you need to take a moment and consider why it is that Buffett’s approach works so well. Buffett finds a strong value proposition to invest in and then sticks to the decision long enough for it to pay off. Bogle almost does the same. Bogle advocates sticking with your decisions, he recommends long-term investing just as Buffett does. But Bogle leaves out a critically important step in the process of getting the odds on your side. His strategy includes no feature insuring that you are investing in a strong value proposition.

That can never work. Not in the long term.

So --

What makes for a strong value proposition with indexes?

If you can manage to tune out all the junk that the investing “experts” have been putting in your head for 30 years now, you probably can guess. Buying a share of U.S. productivity is much like buying anything else. You have lots of experience buying stuff. What is the one thing that you are certain always to look at to insure that you do not get ripped off when buying carrots or comic books or sweaters or printers?

Price!

Indexes can be wonderful, just like all the other things you can buy with money in this Consumer Wonderland of ours. But they are obviously not wonderful at any possible price! Buy indexes at a good price and you are the house. Buy indexes at a bad price and you are arguably something even worse than a gambler -- you are a sap.

Buy indexes at a poor enough price and it’s not just that the long-term odds are not with you, it’s that the long-term odds are against you. Buy indexes at a poor enough price and it’s pretty much a lock that you are going to get a worse return from stocks than you could get from money markets. Yuck! Not good.

Investing could be so simple. The only thing that complicates it is that The Stock-Selling Industry spends hundreds of millions of dollars in marketing expenses trying to persuade you not to take price into consideration. Why would people who make a living from selling stocks want us all to think that we should put our money into stocks regardless of the price at which they are selling? This is a hard one! I might have to think this one over for a few years and get back to you!

I want to free you from the power of the expert stock salesman. I want to teach you how to invest in indexes effectively. I want to teach you to become the house and not the gambler by learning how to distinguish index fund purchases that represent strong long-term value propositions from index fund purchases that represent poor long-term value propositions. I’ll present you next week with a tool that will tell you in five minutes all that you need to know to know whether stocks are going to pay off for you or not.

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